Vale of Tears

Your editor promised to write no more letters until January. Yet hardly had the sun set when he was ready to break his promise. In researching his new book, he discovered something that might interest you. More below…

“Whereas all capitalisms are flawed,” wrote economist Hyman Minsky in 1985, “not all capitalisms are equally flawed.”

The obvious “flaw” in capitalism is that both the capitalists and the proletariat are all Homo Sapiens, not Homo Economicus, the mythical species of economists’ dreams. They do not coldly measure the risk and calculate the return. Instead, they make their most important decisions – such as where to live, what to do, and with whom they will do it – not with their heads, but with their hearts. A man gets married, for example, not after carefully toting up the pluses and minuses. He goes about it not as a machine might – but as a dumb beast of burden…following instincts he will never understand. Thus yoked and harnessed, he lumbers into church as if he were going to war – that is, without a clue. Men do not usually go to the altar or to war after much rational calculation and reflection. Instead, they are swept along by whatever emotional currents come their way…and risk their lives and their comforts for causes which, in the calm of retrospect, usually seem absurd.

“The head is just the heart’s dupe,” as La Rochfoucauld put it. Thinking with their hearts…and caught up in whatever collective madness is fashionable…men do the most amazing things. But that is this vale of tears that we live in. And here at the Daily Reckoning we rather like it.

Minsky’s “Financial Instability Hypothesis” set out to show how capitalism is inherently unstable. He might as well have set out to show that beer goes bad if you leave it sitting out too long or that children get cross if they don’t get enough sleep. For capitalism is a natural thing, like life and death, and like all things natural, naturally it is unstable.

But what is interesting in Minsky’s oeuvre is a little insight that might have been useful in the late ’90s. Readers will recall that among the delusions suffered by investors at the time was the idea that American capitalism had reached a stage of dynamic equilibrium – where it was constantly inventing new and more exciting means of making people rich. Boom and busts were thought to be a thing of the past, first because better information made it possible for businesses to avoid inventory build-ups…and second, because the science of central bank management had attained a new level of enlightenment, wherein it could figure out precisely how much credit the economy wanted at any moment and make sure it got what it needed.

In the absence of the normal ‘down’ parts of the business and credit cycles, the economy seemed more stable than ever before. But Minsky noted that profit- seeking firms always try to leverage their assets as much as possible. He might have added that consumers might do the same thing. Without fear of a recession or credit crunch, Homo Sapiens, whether in the office or the den, were likely to over-do it. “Stability is destabilizing,” Minsky concluded.

Minsky refers to Keynes’ concept of a ‘veil of money’ between real assets and the ultimate owner of the wealth. Assets are often mortgaged…financed… leveraged or otherwise encumbered. This ‘veil of money’ gets thicker as financial life becomes more complex and makes it hard to see who is actually getting rich and who is not. When house prices rise, for example, it seems that the homeowner should be the beneficiary. But homeowners now own much less of their homes than they did a few years ago. Fannie Mae, banks and other intermediaries have a strong stake in home values. In recent years, Fannie Mae has worn a veil of money as sticky as flypaper. The poor homeowner hardly had a chance. He got stuck almost immediately. Now, he’s hopelessly glued and won’t be able to get away without a lot of ouches. But who will feel the most pain? If home prices go down, who will ultimately be left holding the bag? Hard to say…

Instead of coming up with innovative new ways to make people rich, America’s financial intermediaries – notably Wall Street and Fannie Mae – came up with ways to make them poor.

“The financial instability hypothesis,” Minsky explains, “is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated. In contrast to the orthodox Quantity Theory of money, the financial instability hypothesis takes banking seriously as a profit-seeking activity. Banks seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy, bankers are aware that innovation assures profits. Thus, bankers (using the term generically for all intermediaries in finance), whether they be brokers or dealers, are merchants of debt who strive to innovate in the assets they acquire and the liabilities they market…”

In Minsky’s mind, capitalism is naturally unstable and needs government to stabilize it. Roughly, this is also the view of the Democratic Party. In the more orthodox economic view, capitalism is naturally stable and government destabilizes it. Traditionally, this is closer to the Republican Party view. But in the 1990s, even Republicans came to appreciate the stabilizing influence of Alan Greenspan. And now, under pressure from the voters, both Republicans and Democrats cry out for “new policies” to fight the bear market and rescue the nation from deflation.

Here at the Daily Reckoning, we agree with Minsky up to a point: capitalism is naturally unstable.

Unfortunately, government only makes it worse.

As we have seen over the last 16 years, public servant Alan Greenspan exerted a stabilizing influence on world markets. When the markets needed credit, he gave it to them. During his watch at the Fed, the Long Term Capital Management blew up. So did the Asian economies. And then, there was the Russian Default…and the Y2k Scare. Finally, there was the collapse of the Nasdaq and the Great Bear Market. Greenspan met each new threat as he met the last one – by offering the market more credit. Each time, his intervention seemed to stabilize the market. And each time, the financial intermediaries found new and innovative ways to pad out the “veil of money” between assets and their beneficial owners. In the end, if this is the end, Greenspan’s efforts were so successful that they led to the biggest economic disaster in world history.

“In an effort to stabilize the economy,” writes Janelia Tse in the Winter edition of Oeconomicus, “policies are implemented. If policies are successful, the economy booms. Expectations about the expected future returns become increasingly optimistic…riskier behavior is rewarded. This leads to fragility in the economy.”

“From time to time,” Minsky elaborated in his “Financial Instability Hypothesis,” “capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system’s reactions to a movement of the economy amplify the movement – inflation feeds upon inflation and debt-deflation feeds upon debt-deflation. Government interventions aimed to contain the deterioration seem to have been inept in some historical crises.

“In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge [conservative] finance units to a structure in which there is large weight given to units engaged in speculative and Ponzi finance…”

In Japan’s boom, Ponzi finance was offered by banks to their favorite corporate customers. More than a dozen years later, the loans still go bad…and now threaten to bring down the banks themselves.

In America’s boom, it was consumer lenders – notably Fannie Mae – who played Ponzi’s part. Someday, perhaps soon, consumers will regret it. For they must pass through a vale of tears to find their way out.

Your editor, unable to resist…

Bill Bonner
October 16, 2002

“Dow Has Biggest Four-Day Gain Since April ’33,” proclaims a Bloomberg headline, reporting on the return of insanity to Wall Street.

It seems like all the records, going back to the ’30s, are being broken. Never before or since had investors lost so much money…never before or since had stocks gone down for so long, nor industrial production fallen off for so many months in a row, nor profits dropped so sharply, nor bond yields hit such lows – until now.

It is almost as if there were something similar between the two periods…hmmm…

But investors rarely bother with such thoughts. A new poll shows that nearly 2/3rds of them had come to believe that this was a bad time to put ‘substantial’ money into the stock market. So where did all this buying come from? Most likely, it is short sellers who need to cover their positions. Our guess is that the average investor is not buying, yet. He’s still holding and hoping…

“We’ve had so many down days,” said a Virginia investor interviewed by Associated Press. “But I still believe that for the long term some of these blue chips have to be a good investment.”

“Twenty years from now, I think we’ll come out OK,” said another investor from Ohio.


The Sunday Telegraph reports that the typical serious bear market lasts 12 years. But it could be that this is not a typical ‘serious’ bear market, but a rather unusual one. We recall that things did not go particularly well for investors after 1933…and that an investor had to wait until after 1954 before stocks surpassed their ’29 peak.

Of course, that was then; this is now. And right now the shorts are getting squeezed. Nothing fails like success, as we have pointed out on occasion. The short-sellers were making so much money, it had become all too easy and predictable. Stocks went down day after day, month after month – all they had to do was to go short.

Mr. Bear, seeing his opportunity, decided it was time to teach them a lesson. Once the shorts are ruined, we guess, Mr. Bear will go back to his principle occupation – ruining the longs.

In the meantime, more details on the rally from our own Eric Fry in New York:


Eric Fry from the island of Manhattan…

– Another monster rally on Wall Street yesterday – the sort that terrifies short-sellers. The Dow jumped 378 points to 8,255 – bringing its 4-day advance to nearly 1,000 points. The Nasdaq surged 61 to 1,282, for a sparkling four-day gain of 15%.

– The stock rally took the shine off of both gold and Treasury bonds. Gold – the somewhat less precious metal – fell $5.20 to $313.40 an ounce. The 10-year Treasury note also plummeted – driving yields sharply higher to 4.03% from Friday’s 3.80%. Last Wednesday, the 10-year yield touched a 44-year-low of 3.56%. The jump in yield from 3.56% to 4.03% may not seem like anything extraordinary to investors who are unfamiliar with typical bond market behavior. But bond traders would call the recent action “serious volatility.”

– (For those keeping score at home, the Daily Reckoning’s New York office enjoys the early lead in our friendly, cross-Atlantic bond-market debate. I mention this fact, only because I happen to be the guy in New York who has been highlighting the possibility of a bond bubble. The Paris crowd, on the other hand, is partial to the idea that an unshakeable deflation in the US might cause bond yields to fall…Despite the bond market’s harrowing sell off over the last few days, we here in the New York office will not gloat. Certainly, it is far too early to declare a victory. Deflation may yet immobilize the US economy in a sort of macro- economic Ice Age. If it does, however, you can be sure that I will be silent about this topic and will pretend that I never mentioned the possibility of a bond bubble…Stay tuned.)

– The current rally on Wall Street looks very much like a classic bear-market affair. The Dow has jumped 969 points in just four days. Is that a lot of points in a little bit of time? Absolutely. But guess what, the Dow fared even better during the first four days of the bear market rally that kicked off last July 24th. Back then, the Dow rallied 1,009 points over the first four days of the rally. But alas, the gains ultimately evaporated as stocks resumed their decline and fell to fresh multi- year lows. We would not be surprised if the current rally also ends badly. In fact, we would be surprised if the rally DOESN’T end badly.

– A sparkling earnings report from Citigroup helped to power yesterday’s Dow rally. The banking giant’s shares gained 13%, thanks to quarterly earnings that beat the consensus estimate by one magical penny. The euphoria lifting Citigroup shares also gave a boost to the shares of JP Morgan Chase (JPM) which jumped 10%. Ironically, while investors were busy bidding JPM shares higher, the financial giant was doling out pink slips. – “Insiders say the Manhattan-based financial giant may cut as many as 4,700 investment banking jobs worldwide,” Crain’s reported yesterday, “700 more positions than the widely expected number of 4,000. That would be 24% of its total investment banking staff. The firm has already cut about 8,000 employees in earlier rounds of job reductions. The company started handing out pink slips today in its Manhattan offices. This round will include more managing directors, who are among the investment bank’s highest-ranking professionals.”

– The job losses at Morgan are but the latest in a global investment banking industry that has shed about 60,000 jobs since the start of last year. Clearly, business isn’t great. But don’t tell that to all the folks who are furiously buying the shares of JP Morgan and Citigroup.

– Let’s allow the bulls to enjoy their moment in the sun.

– Bullish investors ought to be happier these days…or at least less miserable. But what about the bears? How do they feel?…Suddenly, being bearish on stocks isn’t as much fun as it used to be. Nothing is more emotionally exhausting for these contrary-minded folks than to watch stocks go up every day…especially when they go up a lot every day. But the bears shouldn’t let this rip-snortin’ rally get them down. Stocks will fall again some day…we promise.

– In fact, stocks might start falling again as early as today. After the close of trading yesterday, Nasdaq bellwether Intel reported disappointing earnings…very disappointing. The stock, which had gained $1.42 during the regular trading session, tumbled $2.13 during after- hours trading.

– Intel is just one company, of course…But it is one of the several thousand public companies that is struggling to make money…Stock-buyer beware.


Back in Paris…

*** Last week, before the rally began, we sensed that investors were close to panic. As it turned out, we were right. They just panicked in the wrong direction. So far, though about $8.5 trillion has been taken out of stock market values, investors have been remarkably sanguine. They have retreated in good order…and have pulled off several noteworthy counter-attacks.

One explanation for their calm demeanors was that the money they were losing wasn’t really theirs – it was “house money”, paper gains they had made in the boom phase. “Easy come, easy go,” they might have said to themselves.

Someone won a Nobel prize, we think, for pointing out that the last dollar a man earns is worth a lot less than the first one. It was obvious to us. A man with one dollar treasures it the way a drunk treasures his first shot. By the time he has his last drink, just before he passes out, he barely feels it scouring his gullet. Likewise, when a millionaire adds a buck to his bank account, he hardly notices it.

The “declining marginal utility of money” works in both directions. As people lose money, each dollar they lose becomes more important to them. At first, losses disappoint them. Then, they annoy them. Then, they get edgy…and at some point…they panic to protect what is left.

James A. Bianco reports that investors are near the panic point. Not since the October 1990 stock market low has the average mutual fund investor found himself with no realized profits. The public is now playing with its own money again. Losses, which may have been an abstraction until now, have become very real.

*** “It’s terrible,” said a friend, describing economic conditions in Germany. The DAX has lost 50% of its value. The Neuer Markt, Germany’s answer to the Nasdaq, has gone out of business.

“Germany was more than a quarter century behind Britain at the middle of the last century,” he explained. “Then, Prussia threw out all the old guild restrictions and opened up the economy. Everybody got rich and the German economy became stronger than Britain’s…

“But now they’re putting back all these ridiculous restrictions… it’s crazy. My son’s scout troop went camping in a farmer’s field…They had to get a three- page document signed by the farmer giving them permission and stating all the things the farmer had to do…

“And even if you want to be trash collector in Germany today, you have to go to school for 6 years to get a certificate…”

*** My son Jules is getting ready to go on an exchange program with his school. By coincidence, he is going back to his hometown – Baltimore!

Last night, a group of nervous parents assembled at the Institut de la Tour: “Is it safe?” they wanted to know. They knew that Baltimore was not the safest place on the planet. But now there’s a sniper on the loose in the Washington, D.C. area!

School administrators reassured the parents. The sniper would almost certainly be caught before the kids arrive, they said. And besides, he was just killing lone Americans.

Jules’ class leaves next week. He’ll be staying with a family who, we were told, have been brushing up on their French. “Jules, you should pretend that you don’t speak English very well,” suggested his mother. “Otherwise they might be disappointed.”

*** By the way, I will be in Baltimore myself in a few weeks, too. On November 12th, at our offices there, we’re hosting a VIP cocktail reception just prior to an all- day “total immersion crash course in venture capital investing” which will be held at the Baltimore Marriott Waterfront… both the reception and the investing course should prove interesting. If you’re going to be in the area, please join us.

The Daily Reckoning